Understanding the Earned Income Tax Credit

The Earned Income Tax Credit (EITC) grants benefits to low-income households based on earned wages and the number of children in the household. It serves as an incentive to increase labor and is targeted to households who need assistance but are also working to improve. While this structure has particular benefits for work incentives and earnings distribution, the different categories and phasing creates a complex and intimidating process that must be understood before it can be discussed. Since its inception 42 years ago, EITC has lifted millions of individuals out of poverty, particularly children. However, its positive impacts are balanced with its problems, similar to almost any welfare system. Proposals to reform EITC are a constant topic of interest from both sides of the political aisle. Last year House Speaker Paul Ryan proposed an expansion of EITC, and numerous think tanks have advanced various suggestions over the years. I have compiled what I believe are the most glaring and commonly discussed concerns regarding EITC, and potential solutions to reform it.

What is the EITC?

The EITC was created in 1975 to provide individuals with a supplemental income while encouraging work by stipulating there must be at least one wage-earning individual in the household. Rather than a flat credit for workers under a particular income threshold, it phases in and phases out and is dependent upon marital status and the number of children in the household. As seen in the graph below from the Tax Policy Center, for 2017 a single parent or married couple can receive a credit ranging from $510 (no children) to $3,400 (one child), $5,616 (two children), and $6,318 (three or more children). The phase in period grants the appropriate percentage per additional dollar of income up to the maximum credit (e.g. a one child household would receive an additional $0.34 for each dollar earned up to $3,400). After that maximum credit amount is reached there is a range of earned income where the credit remains the same, and then it begins to phase out. For the phase out period, the credit granted decreases by the appropriate percentage per additional dollar of income until it is zero. The only difference related to marital status is the phase out period for married households starts $5,590 later than single households. To claim EITC, an individual must file income taxes and have a qualifying child, which is a dependent who lives at least half the year with the filer. After filing federal income tax, if EITC is granted, there will be one lump sum given after February 15th of the following year.

Is it working?

The EITC is a great idea in theory. It provides support for low to middle-income families, encourages work, and has a longer period of credit for married households. Rather than other welfare programs, it has an increasing return to work until the plateau, which incentivizes a certain level of labor force participation. The American Action Forum found that individuals receiving EITC work on average 35 hours a week, as opposed to other minimum wage workers not receiving EITC, who work on average 24.2 hours a week. These increased hours contribute to greater earnings, which help lift more households out of poverty. In 2015, in conjunction with the Child Tax Credit, EITC lifted approximately 9.4 million people out of poverty, more than half of which were children, according to the IRS.

However, there are concerns that the EITC disincentivizes work during the phase out period, penalizes marriage, does not support non-custodial parents, and has high rates of improper payments. After the plateau, there is a decreasing return to work, as EITC payment decreases for each additional dollar earned. While there is an incentive to work, the incentive ends after wages reach $18,340. Additionally, if two individuals are working but earning low enough wages to be eligible for EITC, there is no incentive for them to marry and continue working. If they share a child and both make the minimum amount to be eligible for the maximum EITC ($10,000), there is an incentive to remain unmarried because, if they combined incomes, they earn $20,000, which is in the phase out stage. Rather than receiving $3,400, they would earn $3,134, disincentivizing marriage or continuing to work at the same level once married. Also, the maximum EITC for childless individuals and couples is only $510 and it starts to phase out when wages reach $8,340 or $13,930 for married couples, which is a low incentive to work and get EITC over other welfare programs that are not as dependent upon wages. Finally, there is a high improper payment rate, 24.2% for fiscal years 2010 to 2013. While there are problems with improper payments for most if not all welfare and tax programs, this is almost a quarter of EITC, or about $16 billion.

Can we fix it?

Problems arise in any welfare program, but without assistance for everyone or assistance for no one, programs must balance the benefits with the concerns. Because EITC must end at some wage level, it would be difficult to remove the disincentive for work past the plateau. However the phase out period provides a continuing incentive to work and receive EITC, because individuals can continue to earn EITC up to a $30,000 increase in wages past the plateau. Therefore a greater increase in wages should outweigh the EITC value lost, since only a percentage is lost. To address the concerns of a marriage penalty inherent in EITC, the benefit paid to married couples should be greater than the benefit to single parents. Currently married couples receive more room for an increase in income before losing the maximum EITC, but no other benefit. Reducing the implicit marriage penalty would potentially decrease the chances that children are claimed twice or split between two unmarried parents for the purpose of taking a greater EITC.

The last two EITC reforms benefit noncustodial parents and decrease improper payments. EITC has been shown to have a great impact on poverty classification and work hours and would benefit non-custodial parents as well. Rather than encouraging them to claim a child as theirs improperly, it would be better to offer a non-custodial parent EITC greater than the childless benefit and less than the one child benefit. It would provide a greater incentive to honestly report relationships and therefore reduce improper payments, as well as assist child support payments. Additionally, the growing problem of men leaving the workforce highlights the place for increased encouragement of men working. Because EITC necessitates legitimate earnings, providing non-custodial parents (typically the father) with benefits may help encourage men to reenter the workforce. Each step to reform EITC also works to reduce improper payments, but the EITC should also be examined further to combat this. One option is to increase auditing on child claims, particularly residency. By cross-checking children’s Social Security numbers double counting of children could be examined to remove claims by non-custodial parents, one source of improper payments.

Conclusion

EITC is proven to benefit families in poverty, and is supported by the majority of politicians from both sides of the aisle. However, like all welfare programs reforms can always be made. By addressing four main concerns (disincentive for work, marriage penalty, non-custodial parent benefits, and improper payments) the EITC can continue its success at a greater level and be a larger tool for encouraging work and decreasing poverty.